Value–based management considerations in the listing of an agricultural company on the food producers sector of the JSE Ltd

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Value-based management considerations in the listing

of an agricultural company on the food producers

sector of the JSE Ltd

W J Jacobs

Dissertation submitted in partial fulfilment of the requirements for the degree Master of Business Administration at the Potchefstroom campus of the North-West University

Study leader: Prof I Nel

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Abstract

In order for a company to operate effectively it needs to have sufficient capital, structured to such an extent that capital charge in the form of interest cost and required return is minimised. A strong capital base lays the foundation for the ability to generate revenue by implementation and management of a well laid out strategy to trade in either goods or services. Capital is a depletable resource and usually limited in respect of availability. The use of capital for income generation will be a process applying the capital to the most profitable project or venture. The cost of capital can be defined as the possible profit generated from an alternative application. This cost is defined as opportunity cost and it is mitigated by the risk involved in its application. Opportunity cost can also be related to the various investment choices which owners of capital have. Investors will base a decision on the risk return relationship of possible investments. Should an investment yield an acceptable return for the perceived risk, an investor will choose that particular investment. This will obviously depend on whether there are alternatives producing similar or better yields at similar or lower risk levels.

Having an appropriate strategy will only yield acceptable returns through effective balance sheet management and decision-making. Balance sheet management entails the use of debt and equity finance in a way which results in the most profitable financing method or the lowest cost of capital. Equity finance entails the use of shareholders’ funds for financing capital requirements. This is usually done by issuing and selling shares over the counter or in the official market in order to finance operating requirements or to fund investments. For a company to list it means offering its shares to the public on an open trading system. In essence this means that investors have to be recruited. In South Africa, this trading system is the Johannesburg Securities Exchange (JSE)

The purpose of this research is to identify the financial variables or value drivers through which management of farming product traders or food-producer companies can evaluate the expected performance of its shares, should it be listed on the JSE. The results were achieved by defining a comprehensive set of financial diagnostic, accounting and valuation ratios and testing it against the response of the share price. The test was done on the basis of developing multiple linear regression models for each relevant year and

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all companies listed in the particular sector on the JSE, in the defined period. Net Operating Profit after Tax (NOPAT) per share emerged as the most reliable measure of share performance.

Second on the list was residual income calculations and more specifically, derivatives of EVA® principles as developed by Stern and Steward. Research into factors influencing share prices resulted in non-financial factors also coming to light. These factors, however, impact on the long term financial performance.

The end result was a proposal to break down NOPAT into its key elements and identify the operations where these elements can be managed. A system of incentive driven measures is to be developed to drive behaviour, possibly through a balanced score card in order to introduce share value-based management. This will ensure that there are no surprises by the time shares are introduced to the open market.

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Bestuursopsomming

Vir ‘n maatskappy om effektief bedryf te word, moet dit voldoende kapitaal hê wat sodanig gestruktureer is dat die drakoste in die vorm van rente en vereiste opbrengs geminimaliseer word. ‘n Sterk kapitaalbasis lê die fondasie vir die vermoë om inkomste te genereer deur die implementering en bestuur van ‘n weldeurdagte strategie om in goedere of dienste te handel. Kapitaal is ‘n uitputbare hulpbron en normaalweg beperk ten opsigte van beskikbaarheid. Die gebruik van kapitaal vir die generering van inkomste sal ‘n proses wees van die aanwending daarvan tot die mees winsgewende projek of geleentheid. Die koste van kapitaal kan gedefinieer word as die moontlike wins wat gegenereer kan word uit alternatiewe aanwending daarvan. Hierdie koste word gedefinieer as geleentheidskoste en word gemitigeer deur die risiko betrokke by die aanwending daarvan. Geleentheidskoste kan ook gekoppel word aan beleggingskeuses wat eienaars van kapitaal het. Beleggers baseer hul besluite op die risiko-opbrengs- verwantskap van moontlike beleggings. Sou ‘n belegging ‘n aanvaarbare opbrengs teenoor die ervaarde risiko lewer, sal ‘n belegger in daardie opsie belê. Die keuse sal bepaal word deur die beskikbaarheid van alternatiewe wat soortgelyke of beter opbrengste lewer teen soortgelyke of laer risikovlakke.

Deur ‘n toepaslike strategie te hê, sal opbrengste slegs aanvaarbaar wees met effektiewe balansstaatbestuur en besluitneming. Balansstaatbestuur behels die gebruik van skuld en ekwiteitsfinansiering tot so ‘n mate dat dit die mees winsgewende finansieringsmetode of laagste koste van kapitaal meebring. Ekwiteitsfinansiering is die gebruik van aandeelhouersfondse vir die finansiering van bedryfs- of beleggingskapitaalbehoeftes of projekte. Dit word normaalweg gedoen deur aandele uit te reik en oor die toonbank of in ‘n amptelike mark of oop verhandelingstelsel te verkoop. In wese beteken dit dat beleggers gewerf moet word. In Suid-Afrika is die Johannesburgse Sekuriteitebeurs (JSB) so ‘n amptelike mark.

Die doel van hierdie navorsing is om finansiële veranderlikes of waardedrywers te identifiseer waardeur bestuur van boerderyprodukverhandelaars en voedselprodu-seerders die verwagte prestasie van hulle aandele kon evalueer, sou dit op ‘n openbare platform soos die JSB verhandel. Hierdie resultaat is bereik deur ‘n omvattende stel finansiële-, rekeningkundige- en waardasieverhoudings te definieer en te toets teen die

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beweging van die aandeleprys. Die toets is gedoen aan die hand van ‘n veelvoudige liniêre regressiemodel vir elke relevante jaar vir al die maatskappye genoteer in die bepaalde sektor van die JSB vir die bepaalde periode. Netto bedryfswins na belasting (NBWNB) het na vore gekom as die mees betroubare maatstaf van aandeleprestasie. Tweede op die lys was residuele inkomsteberekeninge en meer spesifiek, afgeleides van ekonomiese waardetoevoeging (EWT) modelle soos ontwikkel deur Stern en Steward. Navorsing na faktore wat aandelepryse beïnvloed het daartoe gelei dat nie-finansiële faktore wat aandelepryse beïnvloed, ook aan die lig gekom het. Hierdie faktore impakteer egter veral op langtermyn finansiële prestasie.

Die eindresultaat was ‘n voorstel om NBWNB af te breek in sleutelelemente en die bedrywe te identifiseer waar hierdie elemente bestuur kon word. ‘n Sisteem van insentiefgedrewe maatstawwe moet dan ontwikkel word om gedrag te bestuur, moontlik deur ‘n gebalanseerde telkaart om bestuur gebaseer op aandeelwaarde in te stel. Dit sal verseker dat daar geen verrassings is teen die tyd dat die aandele op die oop mark genoteer word nie.

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Acknowledgements

It is with great appreciation that the following persons are acknowledged for their

contributions towards completion of this mini-dissertation and a worthwhile MBA degree:

Lord God Almighty, for being my resting place when I got tired and for always giving me direction through His servants, my fellow students (especially my study group), my wife, family and friends.

Professor Ines Nel for, inter alia, his effort in laying the foundation for this study and, possibly, my future.

My wife Renata, for her devoted love and support, advice and encouragement to complete this study, for placing everything in her life second to my focus on this study and for the latest addition to the family, Caroli.

My sons Rohann and Lauri, for their patience and acceptance of their father’s studies.

My parents Willie and Dalene, for always encouraging me and believing in me.

Christine Bronkhorst of the Ferdinand Postma Library of the North-West University for the library support and service during this study.

Dr J du Plessis for the advice and assistance in processing the data.

Lorna Keough for her time spent on the grammatical editing of the mini-dissertation.

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Table of abbreviations

Acronym Term

CEO Chief executive officer

CFROI Cash flow return on investment

CVA Cash value added

DCF Discounted cash flow

EBITDA Earnings before interest, tax, depreciation and amortisation EBIT Earnings before interest and tax

EP Economic profit

EPS Earnings per share EVA(R) Economic value added FCF Free cash flow

IRR Internal rate of return

JSE Johannesburg Securities Exchange MVA Market value added

NOPAT Net operating profit after tax PE Price earnings ratio

ROE Return on equity ROI Return on investment

RI Residual income

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CHAPTER 1 Food sector share prices: An overview

The objective of this chapter is to present the study. Firstly, the background will be presented and the subject will be put into perspective, then the problem will be presented and the study parameters laid-out. Finally the layout of the document is set in order to provide a clear understanding of the processes followed.

1.1 INTRODUCTION

The study was necessitated by a choice of an agriculture-related business (agri-business) to list on the Johannesburg Securities Exchange (JSE). This means that company would stop selling its shares in-house and offer it to an official market as will be clarified further in this document. To determine whether it will be accepted by investors on the JSE as a company that will meet or exceed the expectations of the shareholders, it is important to compare the performance of the company and its shares with companies it will be joining in the same sector.

Currently there is only one company on the JSE with nearly the same business model. Unfortunately there is not much correlation between this company’s share price movement and that of similar unlisted companies. The fact is that some unlisted shares are currently outperforming certain listed shares in this sector. The concern for a company with listing in mind is whether investors perceive the risk of similar companies different than other investments or whether some listed companies really did not perform as expected by investors. In order for a company to operate effectively it needs to have sufficient capital. The capital will be used to purchase assets, which in turn are used to generate income. (Megginson et al. 2007:49).

The company with a strong capital base has the ability to generate revenue by implementing and managing a well laid out strategy to trade either in goods or services. Capital is a depletable resource and is usually limited in respect of availability. The use of capital for income generation will be a process of allocating it to the most profitable

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project or venture. The cost of capital can be defined as the possible profit generated from an alternative application. This cost is defined as opportunity cost and it is mitigated by the risk involved in its application. Opportunity cost can also be related to the various investment choices which owners of capital have (Megginson et al. 2007:158). Investors will base a decision on the risk return relationship of possible investments. Should an investment yield an acceptable return for the perceived risk an investor will choose that particular investment. This will depend on whether there are alternatives producing similar or better yields at similar or lower risk levels.

Having an appropriate strategy will only yield acceptable returns through effective balance sheet management and decision-making and whether the effectiveness and efficiency of companies can be optimised. Balance sheet management entails the use of debt and equity finance in a way that results in the most profitable financing method or the lowest cost of capital (Megginson et al. 2007:568). Equity finance entails the use of shareholder funds for financing capital requirements. This is usually done by issuing shares and selling it over the counter or in the official market. For a company to list it means offering its shares to the public in an official market to generate capital to service operating expenditure or to fund investments or projects. In essence this means that investors have to be recruited. In South Africa the official market bringing together investors and firms in need of investment, is the JSE.

Investors will have to be convinced that funds invested will realise decent returns, that these returns are sustainable and sufficient to justify the risk and also that it has the ability to enhance the investor’s current portfolio. Investors have certain goals in mind when choosing investments and it is necessary for the company to understand these investment goals (Megginson et al. 2007:173). Convincing investors that the required investment goals are achievable or that a company can add to the achievement of these goals is of the essence. With regards to the above management of the business, there must be certainty that the business has a successful growth strategy, which will enable it to deliver the returns which are expected by the investors. In addition, the delivery of the returns should be sustainable in order to convince investors to select the company shares as investment.

Given the importance of an understanding by management of shareholders' requirements it is necessary to be sensitive to the reaction of shareholders on certain

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conditions or circumstances and how certain reports delivered by the company are read and interpreted. Should the company be able to predict the reaction of the shareholders, the company would streamline its planning and execution of tasks and would confidently implement projects. This will empower the company's management to set up a successful communication channel in presenting reports. By effective communication and offering acceptable results, the management of the company will be able to lay a solid foundation for share value growth through shareholders' confidence in the company’s long term sustainability.

In essence this means that a study had to be done to determine the factors influencing the share price for the companies in a sector by, in this case, doing an analysis of the companies in the food sector. Specifically important is financial performance and its influence on share price. By getting a correlation between performance measures, value drivers and share price movement, it would be possible to establish whether key drivers can be identified, based on which shareholders or potential investors will make their buying or selling decision in respect of the trading with shares.

Even though there is a possibility that it will not be possible to manage some of these measures, will make sense for a company to at least understand the direction which share trading and share prices will take when certain decisions are made or certain performance levels are delivered. With the information at hand and understanding the visible trends, an attempt will be made to model share price behaviour.

The purpose of the research will be to create an understanding of the factors that a company would have been exposed to if it was listed on JSE over that specific period and what its share price would have looked like under those circumstances. The final outcome of this study will be an attempt to create a realistic picture of what the company can expect as a listed company. The latter will allow for successful strategic planning, implementation and management, bearing in mind the fact that it will influence share prices and the way in which the share price will react.

Of the more important financial aspects to be considered is the growth in earnings per share (EPS), earnings before interest, tax depreciation and amortisation (EBITDA) and profitability (Megginson et al. 2007:50). A list of possible variables will be developed from literature and initially included in the study in order to define its influence on the

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share price. By processes of elimination these measures were narrowed down to only the most relevant ones determining the share price, using multiple linear regression analysis.

A study done by Ernst & Young in 2008 indicates that institutional investors base an average of 60% off their decisions on financial measures, while 40% is based on non-financial measures. The non-non-financial measures have a longer term impact on the sustainability of the investment and can also be seen in the financial results of the company. The non-financial measures with possible influence on the share price include, inter alia, the reliability of management, corporate strategy and the strength of the trademark.

In consideration of the above information the study aims to identify the key elements which influence share prices (and indirectly shareholders), resulting in a usable guide for similar companies which aim to list on the JSE. Due to the varying influences on different sectors the study will be done specifically on the food sector, particularly on farming and food producers. This particular study is aimed at current unlisted agri-businesses intending to list in the food producers sector of the JSE, due to its main operating income being derived from farming and food production.

Although the other companies in the food sector do not have similar business plans, similar business cycle patterns are indicated. The fact that most of these companies are low growth, relatively acceptable yielding companies with a low beta against the rest of the JSE, means that it will suffice as defensive shares for investors looking for low-risk opportunities. The agri-business will compete against these companies for an opportunity to be on an investor's portfolio and has to know when and why an investor will look at a particular share.

The study is split between a literature study on the various ways to measure company and share price performance and its ability to predict share price movement; and an empirical study analysing the share price history of companies listed on the JSE in particular, the food producer sub-sector of the main sector farming and fishing. The main source of information for listed companies will be information provided by McGregor BFA.

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It is important to know what is to be expected in terms of company performance in order to be the share of preference as well as to anticipate what the share price reaction will be on certain actions taken by the company. The ability to model these expected changes will create a good idea of the expected share price.

For purposes of the research, the past 19 years' financial performance ratios of the JSE listed companies will be used to analyse the share movement in relation to financial performance.

1.2 BACKGROUND TO THE STUDY

In its aspiration to remain the market leader in the agricultural sector, a company should continuously investigate opportunities or methods to set up the most effective delivery platform for the building of shareholder value. Historically agricultural co-operatives were set up for the purpose of delivering value for the members. By converting to companies, ownership of agri-businesses has changed from membership to shareholders. However, the purpose of creating value has not changed.

Managing shareholders value and growing it require effective balance sheet management - especially a balance between using debt finance and shareholders’ investment (equity finance) as sources of capital for business generation. It also requires building the confidence of investors in order to grow the investment value within the company. When considering listing, an investigation as to whether optimal methods are being used for creating and building value of the company's shares at listing on the JSE, is necessary.

Due to the low trading volume of unlisted shares as well as limited knowledge of the existence of these types of companies, it is expected that listing shares on an open platform will create increased trading volumes and also unlock the perceived inherent value of the company. Doing this is perceived to be a bold move for companies not entirely sure of what to expect in a listed environment. In order to shed some light on what can be expected and how to anticipate the value and price movement shares can

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experience in a listed environment, it will be attempted to find the value drivers and model the impact thereof on the shares of unlisted companies when they list.

Based on the above it is currently unsure which variables have to be managed to such an extent that a realistic share price will be achieved at initial public offering. It appears as though the most up-to-date topic in the management discussion on financial management is related to a value-based management (VBM) as part of residual income theories. Chapter 2 discusses these topics in more detail.

1.3 PROBLEM STATEMENT

To determine what value drivers can be identified which will influence the movement of share prices for an agri-business company listed on the JSE and what can be done to ensure share performance.

1.4 OBJECTIVES OF THE STUDY

The following objectives were set in order to confirm whether the study met the required criteria

1.4.1 Primary objective

The primary objective of the study is to develop a framework for the understanding of variables influencing share price changes and management of share value.

1.4.1.1 Secondary objectives

Establishing the relevant variables which may have an impact on share price movement by way of a literature study.

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Analysing share price movement and the variables influencing it by developing multiple linear regression models.

Determining which of the variables in the model has the most influence on the share price.

Developing a framework for management as a tool in the daily operation of the company.

1.5 SCOPE OF THE STUDY

With an emphasis on financial management, the study will be limited to the fields of financial strategic and operational management and packaged under value-based management.

1.6 RESEARCH METHODOLOGY

The methodology used will be a combination of literature and empirical study.

1.6.1 Literature/Theoretical study

The foundation of the study firstly consisted of a theoretical cornerstone of research into the specific area of financial ratio analysis and residual income theories of value management and the effect of these forces on the share price movement, especially in the first three years after listing.

1.6.2 Empirical study

14 companies are currently listed on the JSE Food Sector, but due to the fact that there were a few which came and went, it will be necessary to include the full group available

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for the past 19 years since 1990 and to also include the factors which allowed for introduction as well as de-listing.

The financial history of the food companies as mentioned above will be drawn from McGregor BFA in order to analyse certain key variables as identified through the literature study to be possible drivers of share price as well as the measurement of company performance. By doing multiple regression analysis on share price movement and comparing it with the key variables, the ability of these measures to determine and predict the share price will be calculated.

The aim is to identify key financial variables that may influence the share price movement.

1.7 PARAMETERS TO THE STUDY

The study will be done with all available information from 1991 to 2009 based on standardised financial records and share trading reports of the companies listed on the JSE Food Sector as provided by McGregor BFA.

1.8 LAYOUT OF THE STUDY

Chapter 1 Food Sector share prices: An overview

Introduction, problem statement and objectives

Chapter 2 Financial variables, company value and value-based management

Background on accounting ratio analysis and recent developments in the area of financial management and strategic management. Theories developed in relation to key elements of share price movements with closer reference to residual income theories.

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Chapter 3 Research method and data analysis

Statistical analysis of companies in the Food Sector on the JSE and interpretation of results.

Chapter 4 Empirical study: recommendations and conclusion.

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CHAPTER 2 Company value and value-based management

The objective of this chapter is put into perspective the factors which may influence company value with reference to share prices and what can be done to understand the effect of management influence in determining share value. Financial and accounting variables are defined and put into perspective. This lays the foundation for the empirical analysis of financial and accounting variables and its relation to share price, in order to be used as value based management tools. Value-based management is defined and discussed in the context of share price management.

2.1 INTRODUCTION

The purpose of a profit orientated company is to ensure sustainable shareholder investment growth or in other words: “Create shareholder value” (De Wet & Du Toit, 2007:59). From a shareholder's perspective this means that the company should be able to perform at such a level that it can sustain the underlying value of the share.

Even if most of the value is perceived and not necessarily capital supported, management needs to be able to understand the origin of value and how to positively manage it in all instances. This, in essence, means that management needs to know what drives the value of the share and to develop the tools to measure and manage these drivers. Bokpin & Abor (2009:1) supports this argument by suggesting that growing the assets entrusted to management through constant effort is of the essence. Knowing what the share value drivers are and being able to measure the drivers, enable management to manage those drivers that may have an impact on value creation. The focus must be on the underlying operational and managerial actions required to maintain or improve financial performance, whether it be the choice investment, financing of assets or working capital management.

From a general financial theory point of view and intuitively one would suspect that share prices are driven by the same fundamentals that drive the economy (Somoye et

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demand for a product, given the same level of supply, will increase the price of such a product. Similarly the price will rise by the same level of demand but reduced supply. The exact opposite will happen if either the demand decreases or the supply increases, should the other factors remain constant and should prices decrease. It can also happen that prices can stagnate due to a lack of supply or demand side forces (Carbaugh, 2007:43).

To establish a fair share price it is therefore necessary for the shares to firstly be available for sale and secondly that healthy supply and demand forces are active. In this regard it is necessary to realise that both the buying and selling decision are driven by information available on the performance and perceived quality of shares. Choices based on this information are the same as in the case of contemporary economics (Carbaugh, 2007:42).

It is necessary to note that the timing and quality of information impact on the true value created from this information. The latter creates interesting dynamics, because supply and demand are again driven by perceptions and preferences based on the interpretation of the available information. The question thus remains: Based on what information do shareholders/investors sell or buy shares?

2.1.1 Market efficiency

One of the methods managers can use to ensure that investors get an accurate picture of the company and what management expects will be the outcome of their effort, is by following the signalling model. To understand signalling one needs to understand the underlying efficient market hypotheses. Megginson, Smart & Gitman, (2007:382) expand on three types of market efficiencies and deliver proof to the concept of overreaction. Market efficiency, according to financial theory, can be divided into weak, semi-strong and strong form.

The following table depicts the definitions and identification of each of the mentioned forms of market efficiency.

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Table 2.1: Market Efficiency

Form of Efficiency

Definition Example

Weak Financial asset (stock) prices incorporate all historical information into current prices;

future stock prices cannot be predicted based on an analysis of past stock prices.

Nothing of value is to be gained by analysing past stock price changes, since this does not help to predict future price changes. This renders "technical analysis" useless.

Semi-strong

Stock prices incorporate all publicly available information (historical and current). There will not be a delayed response to information disclosures.

The relevant information will be incorporated into a stock price as soon as the information becomes publicly known.

Strong Stock prices incorporate all

information - private as well as

public; prices will react as soon as new information is generated, rather than as soon as it is publicly disclosed.

Stock prices will react to a dividend increase as soon as the firm's board of directors votes - and before the board announces its decision publicly.

In essence an efficient market means that the share price responds almost immediately to changes in the business environment or company performance expectation, once the information becomes publicly available (Drake, 2007:4). In cases where the markets are perceived not to be fully efficient, methods of communicating with investors are developed.

One of the methods of share market communication is called signalling. The signalling model was developed by Ross and others in the 1970’s (Megginson et al., 2007:502) to make sense of the information gap between management and investors. One example used by Megginson is of a company expecting excellent returns in the near future, taking on debt financing, which causes repayment commitment, to prove their

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ability to service this debt. The logical reaction will be for investors to trade the share price to higher levels in expectation of higher investment yields caused by increased capital. The reason investors will expect a higher yield on investment in the company’s shares is that an increased capital requirement is most probably a result of investment in new projects or growth by the company. It can also mean that the company perceives its share price to be too low and as a result rather takes up debt finance than equity for the purpose of investment in growth.

It is argued that the weaker the efficiency in the share market in which companies operate, the higher debt financing it is prepared to take up to signal its future profitability. Research indicates that a positive correlation exists between an increased use of debt finance and market efficiency. The relationship is, however, not significant. (Megginson et al., 2007:503).

Signalling can be used in various ways to inform less informed investors, like using dividend payouts as a way to communicate to the investment community satisfaction with the performance of the company or in a “negative" sense to communicate that viable investment projects in the field of business are not available. The latter may lead to a perception that a company is moving into a maturity phase, which in turn has specific implications for the market price of the share. One of the less conspicuous ways of signalling is using market timing. Market timing means that companies tend to issue shares at the time when share value is perceived to be at a high and buy in when the share value is perceive to be low (Megginson et al., 2007:504).

Considering the fact that supply and demand for shares are probably derivatives of underlying information one has to consider what influence supply and demand have on share price determination. Another issue constantly referred to regarding investment decision-making in financial theory is the so-called risk return relationship (Megginson

et al., 2007: 45).

2.1.2 Risk and return

Investors, according to financial theory, will logically be looking for the largest possible reward (return) on investment and minimal risk of losing any of the capital invested.

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Risk and reward theoretically, and maybe specifically for risk averse investors, have a positive correlation, thus the higher the perceived risk, the higher the required return to entice the investor to invest. The final choice whether to invest in a specific asset or opportunity seems to be determined by the individual’s risk aversion profile. By being able to determine the risk in investing, the choice will fall on an investment where the perceived positive gap between reward and risk is the greatest, in line with the risk profile of investors (Megginson et al., 2007:180).

2.1.3 Evaluation and measurement

The first step in considering an investment in a company is to understand its business model. The business model is derived from the identification of certain strategic drivers, mostly spelled out in the non-financial sections of the annual financial reports. The management of most companies try to explain the business model followed, using various methods of breaking down the business into segments and mostly through schematic illustrations and diagrams of how the units are integrated. The mentioned can be used to identify the key drivers of the business and eventually allows ways to analyse the company’s ability to grow core competencies into competitive advantages. Measures to evaluate the effectiveness of strategy and execution usually can be derived from comparing efficiency and growth within and amongst companies (Thompson et al. 2010:107). Regarding future performance expectations it is specifically important to pay attention to the strategic direction and focus indicators as spelled out in the chairperson's and other reports contained in the annual financial report.

Investors' evaluation of companies as prospective candidates often starts by looking into a company’s financial reports and if available, in the case of a company intending to list, its prospectus. From the financial reports the financial variables are analysed and put into perspective, mostly by considering trends within the company but also by comparison with similar companies. The prospectus explains the investment story of the company, giving more than just the financial background but also explaining the reason for listing and value proposition for investors. In the listing prospectus, the strategy and building blocks for generating future income is expanded on. In combination with the managing director's and often the financial director’s reports, most

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of the non-financial issues are discussed. The non-financial issues may include reference to the effectiveness of execution and relevance of company strategy for the past period and for the future. It may also include a change of direction and focus and a variety of other indicators. Other indicators and issues often referred to in the prospectus and financial reports, may include execution of strategy and the use of brand, marketing and advertising efforts as well as corporate governance and compliance issues. Fox (2003:3) suggests that the share price will overall reflect a more accurate picture of the company value, especially if the disclosure in financial statements complies with legal requirements.

While non-financial factors are not necessarily clearly visible in the financial reports, the perception is that the effect of non-financial issues may be visible, derived from, and can be interpreted from using financial measures. Thompson et al. (2010:103) is specifically of the opinion that financial measures can clearly indicate strategic direction and execution. The financial reports are perceived to be the most accurate available reflection of the operating model and the performance of the company. Due to the diversity of businesses and operating models, it is recommended not to only look at one company in isolation. In order to judge a company’s performance it needs to be benchmarked against companies with similar operating activities. Comparison between companies unfortunately poses its own challenges since the information and the way it is presented differ from company to company.

General methods of evaluating share investment returns and company performance are based on earnings multiples. Earnings multiples, as the term suggests, are ratios built on the relationship between share price and company earnings as expressed per issued share. Bringing the share price in perspective with the underlying company’s results gives an average investor a basis from where to determine the market’s impression of the company. Many earning multiple metrics currently exist - some of the most popular methods are discussed.

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Price-earnings ratio (P/E)

P/E is defined as a company's share price divided by its earnings per share (EPS) in a specific financial year. EPS is mostly used for the most recent year and it is calculated as the net profit after tax divided by the number of shares in issue at the end of the year or the average number of shares in a particular year. Price/earnings is often used in peer group context, in other words what is an acceptable P/E ratio for a specific industry or sector. This approach leads to an “assumed relative stable” P/E for a company. The reason for following this approach is that a fair P/E for a company cannot be established. The problem is that EPS is the only value in the equation which is known therefore a fair P/E for a specific company cannot be calculated using the above equation. Bosman (2007:38) argues that even EPS cannot be considered as a constant since a variety of factors including changes in capital structure and company operations can change earnings and should impact on the ratio. Notwithstanding the above, P/E is currently the most popular valuation measurement (Hillestad & Bank, 2007:127). The popularity of P/E may be due to the fact that it is easy to understand and calculate. Other calculus exists to calculate a fair P/E. However, due to its own complexities and underlying assumptions it will not be discussed.

Price-sales ratio (P/S)

P/S is defined as a company's share price divided by the relevant 12 months' sales-per-share. An advantage of using price to sales is that the source of future income, namely sales is measured, irrespective of the efficiency of the company’s internal operations. As a result of measuring pure sales growth, an opinion can be developed about the market share and growth prospects of the company. This should give an investor a snapshot of expected growth, especially if price to sales is compared between years and analysed as a trend. Long term investors will accept that companies may experience seasons of low sales, but in the long run sales turnover should smooth out, giving a clear indication of growth trend.

Variation in terms of sales and sales revenue, which might not be directly related to growth or the lack of growth, is cases where, for instance, sales margins were reduced to increase market share or compete against a rival firm. In the case of reduced sales margins, sales revenue may grow, but not necessarily gross profit, possibly creating a more positive perception of growth than what might actually transpire once the net

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profit becomes known. Where sales margins are increased to increase profitability it could result in loss of sales revenue, but not necessarily profitability as a whole. The perception could be that the company experienced negative growth but the net profit may even have increased. Sales margin can be increased by decreasing cost-of-sales or increasing sales price. Similarly sales margins can reduce by reducing selling prices or increased cost-of-sales. More detail will be provided later in this chapter.

Price-book (P/B)

A company’s net asset value is the net value after all the liabilities are deducted from the company’s total assets and is equal to its book value, thus its assets less its liabilities. To calculate the price to book (P/B) ratio one has to divide a company's share price by its book value per share. P/B ratio is considered a good measure for value investments. It also gives a clear indication of the market sentiment regarding the expected value of the share and its possible future profit. A high price to book ratio indicates that investors perceive the company to be able to be more profitable in future. The latter means that the current asset value or book value is considered to be too low.

A company’s assets are used to generate income. Indications are that if a company’s profitability is higher than expected, the additional financial benefit gets discounted by investors in the share price. In this regard (Hillestad & Bank, (2007:128) indicates that a high price to book ratio may mean that the investors believe the company will outperform its normal projected growth. Interestingly Bokpin & Abor (2009 :31) found a considerable correlation between capital structure and price book ratio, suggesting that investors discount the debt ratio in the share price. A high debt ratio consistently resulted in a lower price book ratio. It is derived that investors may be concerned about the ability of a company to meet financial commitments, amortise debt, compensate shareholders or to reinvest funds for future growth.

In South Africa the most popular methods of valuation are earnings multiples as discussed above and the discounted cash flow (DCF) methods, to be discussed later (Correia & Cramer, 2008:48).

The above variables are used to determine the value of shares but do not necessarily indicate how the value is created or where it originated from within a company’s operations. Financial ratios were developed in order to standardise the approach in

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which company performance is evaluated. Secondly, financial ratios are used as diagnostic tools to determine whether resources are used effectively and efficiently. Using standardised ratios allows for comparison across companies, which facilitates benchmarking. The benefit of benchmarking is the ability to identify inefficiencies or areas of excellence in a company. The use of financial ratios as indicators of where share value is generated in a company is perceived not to be a clear science. In this regard a substantial number of financial ratios and measures were developed in order to truly measure company performance.

These financial ratios are calculated by analysts and investors from information provided in financial reports. Financial reports, however, contain historic information and the investor needs to determine possible future performance of the company in order to ensure good investment returns. Of these financial ratios the most popular ones are discussed for possible inclusion in the empirical study. The discussion follows later on in the chapter. It is also important to remember, as per previous discussion, that some of the factors influencing a company’s performance are of non-financial origin. These non-financial factors would be hard to measure in the same way that financial factors are measured.

In order to include consideration for the effect of non-financial factors on share prices, the aim is to be able to develop a set of measures which indirectly relate to the measurement of non- financial factors as well. In other words, one has to find financial measures from which the influence of non-financial performance results can be derived. It is suggested that non–financial factors tend to impact on financial measures at later stages. Impacting at later stages means that the ability to understand the non– financial drivers of the company can enhance the accuracy of determining the outcome of the performance in future. Thus, through diagnosis of the financial factors, non-financial issues can be laid bare. Non-non-financial issues are discussed and put into context of company performance later on.

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2.1.4 Financial assessment

When reporting on financial results, companies tend to produce an own perspective of performance and this is done by means of comparing history. Accounting standards GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) prescribe a certain set of financial reports which should always be part of the annual financial reporting process. Financial details are set out in annual financial reports to the extent where it most accurately reports the past year’s performance and the financial position on the last day of the financial year. Investors use the mentioned reports to make comparisons between companies in order to determine the best investment from information provided.

Financial reports normally comprise of the following (Megginson et al. 2007:31):

1. Income statement. 2. Cash flow statement.

3. Changes in shareholders’ equity; and 4. Balance sheet.

In order to make financial reports more understandable, each financial statement is accompanied by notes, allowing readers to see a breakdown of the values or policy and procedures followed in the compilation of the specific financial report.

The information at hand thus allows the investor to see the company in terms of income and profit generated, capital availability and deployment of funds.

Companies use resources, popularly known as: Men, Money, Machines and Materials. Men, referring to the people with certain skill sets to perform tasks in order to achieve a mutual goal. Money refers to the available capital and the systems used to plan and monitor its movement. Machines, in the case of production companies, but it can also refer to the equipment necessary for service companies to deliver service. Material includes all resources being transformed from an input to a product or service.

The financial results of the business activities are summarised in the income statement and the use and application of capital are reported on in the balance sheet. The

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income statement is therefore a measure of effective operation of the company, while the balance sheet indicates the final movement of capital, mostly to indicate the extent to which the profit generated by the company contributes to the owner’s equity, but also to give a breakdown of the distribution of capital to operational activities - the result of the structure of financing of activities.

2.1.5 Share performance

Shareholders can obtain value from investments by two means only: Share price growth and dividends received. Dividends are fully company controlled and are dependent on the market conditions, company strategy and the actual financial performance of the company – specifically related to earnings yield; cash generated and cash requirements for future use. Companies mostly issue dividends to achieve two goals, the first being to send a communication to its investors regarding its performance and financial condition and secondly to entice prospective investors to invest in the company (Megginson et al., 2007:551).

Investors use these dividends to determine the share price through the “Gordon Growth model:

P0 = D1/(r – g)

Where:

P0 = the current share value

D1 = the dividend at the end of the first year

r = the cost of capital or required return for the investor and g = the expected growth rate of the company

the expected growth rate is determined by establishing the retention rate of profit generated, in other words the balance of the profit of the company, reinvested into future growth after payment of dividends, as a fraction of the ROE (Megginson et al. 2007, 155):

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g = the growth rate rr = the retention rate ROE = return on equity.

Calculating the share value using the Gordon Growth model will give an investor a good indication of the price to pay for a share. However, there are pitfalls in the sense that dividends can be paid from capital resources and not necessarily from profits generated. Dividends can also be paid in different forms as Ben Temkin (Temkin:2010) discovered when looking at the dividends of a specific company in detail. The dividends were paid by way of giving shareholders more shares. As a result the capital support for the share prices was diluted and the dividend value was stripped from the share value.

Share prices seldom follow the Gordon Growth valuation, mainly due to the unpredictability of ROE or growth and issues like the Tiger dividend as per the previous paragraph. “Share price movement can be influenced by the market’s view of the sector or the company, rather than the performance of the company.” This was quoted by Seal, (2010:105) as the words of John Mayo in articles published in the Financial Times, giving his account of his part in the debacle of a well-known American electronics company in 2002. In brief, the share price of the electronics company took a turn for the worst, despite perceptions of the company that it was still performing well, mainly due to poor performance of certain investment choices it made. This created a general concern about the competency and strategic direction of the leadership of the company and resulted in a discounting of the share price.

In most instances there are only two opportunities per annum at which a company can truly publicly confirm its financial performance, namely at financial year-end – in which case external auditors can verify performance and then at mid–year, where investors depend solely on the integrity of the company to provide an accurate reflection of financial performance, because interim statements are not audited. Some companies deliver quarterly statements as well, but there is a cost involved and the benefit must outstrip the cost to justify such an action.

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In the meantime, the share prices fluctuate on a daily basis and produce significant changes, seemingly without any changes in information regarding their financial performance. This leads to the question: “What role does the financial results and performance measurements play in the value of the share, what is recognised as the major contributors to share price variation and how should these matters be handled by the management of the company?"

Van den Heever (2007:108) concluded in her dissertation regarding share price movement and capital structure that net operating profit after tax (NOPAT), net profit after tax (NPAT) and free cash flow (FCF), of which NOPAT is a building block, have a significant correlation with share price movement in the industrial sector of the JSE. This result agrees with the basis of Koller’s (1994:1) argument that generated cash is the only accurate measure of a company’s value.

2.1.6 Analysis

In order to test the above arguments regarding financial variables correlating with share price movement and to statistically prove or reject the ability of certain ratios to predict or at least correlate with share price movement, it is necessary to, within reasonable logical sequence, present these ratios, define them and argue the reason for their inclusion in the statistical analysis.

The logical analysis will actually start from a beginning balance sheet, containing all the capital information needed to understand the base of revenue creation and profit generation, back to an ending balance sheet, showing the outcome of the combination of capital and activities in generating further capital.

For the purpose of this presentation, the sequence of discussion will be in line with the order of appearance of information as contained in financial reports, which starts with an income statement. What needs to be borne in mind is the fact that it may not necessarily mean that the share price will move positively with delivery of positive results. Results which are in line with expectation will hardly ever produce a change in share price, because it has already been factored in by the time of publication (Hillestad & Bank, 2007:117).

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2.2 INCOME STATEMENT

An income statement is a report that reveals the efficiency and effectiveness of the operations of a company in financial terms. Therefore values in and ratios that can be calculated from income statement figures may be important, not only in the management of operations but also in the context of value creation. Some of the measures considered important in context of the above will be discussed below.

2.2.1 Profit margins

Profit margins are normally expressed as percentages simply because it allows users to easily compare figures. It should be borne in mind that a variety of profit margin figures can be calculated using different formulae. For the purpose of this study attention will be afforded only to gross, operating and net profit margin. If expressed in percentage terms, the profit margins mentioned above indicate what percentage of sales is left after the deduction of costs. The purpose of using profit margins is to establish the quantum of surplus funds generated after subtraction of specified expenses.

It is important to note that profit margins do not measure cash generated - it only measures the difference between specified variables in line with generally accepted accounting practice (Kew et al., 2006:518). When used, it must be considered in conjunction with the total cash cycle and realising that the cash cycle may have an influence on margin values. The argument regarding cash cycle emphasises, namely that care needs to be taken that every aspect which may influence profit margins is considered when distributable reserves are determined.

The following is a more detailed look at the various profit margins measured.

Gross profit margin

Gross profit is calculated as sales less directly attributable costs; in other words the amount of money that remains after direct production costs have been subtracted from

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sales. Direct production costs include the following type of costs: overheads, labour, office, fuel, resources and other used to operate the company.

The gross profit margin expressed as a percentage measures the percentage difference between sales and cost of sales. From a management point of view gross profit margin is an important measure because a positive profit margin indicates that the company is able to cover direct attributable costs. Naturally the bigger the gross profit margin the better. Gross profit margin is calculated as:

(Sales - Cost of sales) / Sales X 100

Given that a high gross profit margin is preferable in terms of the goal to create wealth for shareholders and stakeholders, it is important to understand how management interventions may influence gross profit. It is for example necessary to understand that an increase in sales without an increase in costs at a slower rate than the increase in sales, would not lead to an increase in the gross profit margin. On the contrary, a decrease in the cost of sales will lead to an increase in the gross profit margin if sales are kept constant. In this context the important aspects to manage are the factors that contribute to the cost of sales. Similarly one has to understand that the lowering of the mark-up percentage to increase sales may lead to an increase in gross profit, but it will not lead to an increase in gross profit margins if the cost of sales is not reduced proportionally. One also has to understand that an increase in gross profit will lead to an increase in operating profit or operating profit margins, provided that the operating cost is kept constant or increases at a slower rate than the rate at which gross profit increases.

Correct interpretation and understanding the relationships between the variables that influence gross profit margin, some of which have been discussed above, afford management the opportunity to adjust management activities in order to achieve the goal of wealth creation.

The bigger picture of the gross profit ratio is an indication of the ability of management to accurately utilise the gap between cost of sales and sales, without negatively affecting sustainability. Sometimes high margins can be maintained despite a large competitive market and that could indicate advantageous marketing effort.

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The formula sales/cost of sales has a complex base because cost of sales is defined through effective stock control, purchasing and manufacturing efficiency. It can, for diagnostic purposes, be broken down into its elements but the information may not be available in the financial reports.

Operating profit margin

After subtracting overhead costs, the operating profit of a firm is calculated, indicating how much surplus capital is available for repaying external finance charges (interest) and tax and eventually how much funds are available for distribution to shareholders or for reinvestment. The purpose of this measure is to isolate operating activities from financing activities and tax in order to measure operating efficiency (Megginson et al., 2007:51).

Calculated as

Operating profit/Sales X100

its purpose is to isolate interest and tax from the net profit formula in order to see the profitability of the company before financing repayments and tax deductions. Sometimes companies tend to do capital restructuring in order to reduce tax. This has nothing to do with whether the company operates successfully, and successful operation is the backbone of sustainability.

Net profit margin

Calculated as:

Net profit after tax/Sales X100

This ration is expressed as a percentage of sales.

After the gross profit measure, operating expenses are subtracted to establish net profit generated. It is important to note the fact that this ratio does not measure cash generated (Kew et al., 2006:518). As percentage of total sales, net profit will provide a way to compare the effectiveness of operations of companies. It can also indicate

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whether the company generates sufficient gross profit to service the operations effectively.

2.3 FROM THE INCOME STATEMENT TO THE BALANCE SHEET

While the income statement gives a view of business conducted, the results of operations are summarised in the balance sheet and movement can be seen in terms of a beginning and end balance sheet.

2.3.1 Profitability in terms of capital utilisation

Although profitability is a good indication of operational efficiency, it has to be put to perspective in terms of its relation to capital utilisation. In order to achieve this, net profit after tax is put into relation to various combinations of capital utilisation and information is derived as to how effectively assets were utilised.

2.3.1.1 Return on Assets (ROA)

As derivative of invested capital and due to the fact that investors' funds are usually invested in assets in the company, it is necessary to determine whether the return on assets have an impact on share price movement. ROA compares income to the total assets used to earn the income. Managing assets from a value based management point of view will intuitively result in more effective asset utilisation, followed by improved return on assets.

The ROA ratio combines the income statement with the balance sheet. It specifically points to the efficiency of use of assets. ROA is influenced by the profitability of the company in terms of net profit, with the use of capital in terms of assets. Keeping the assets at the same level and improving profitability will improve the ROA and vice versa, while keeping profitability at the same level by utilising less assets will also improve the ROA.

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The main problem arising from the use of the ROA ratio is the fact that it reflects the use of all capital and does not give an indication of which assets are being used less or more efficiently. Distinguishing between current and non–current assets and calculating ratios in respect of the effective utilisation of the last two mentioned balance sheet items are expected to be necessary to truly predict the effectiveness of managing these ratios in terms of share value.

The research of Alexakis et al., (2010:132) suggested that ROA along with other ratios did not have a significant impact on share value for companies on the Athens stock exchange. The mentioned results, however, are contradicted to a certain extent by Prakash et al., 2003:2), concluding that the adoption of the EVA® consideration in financial management processes was expected to impact positively on, amongst others, profitability and debt management, both of these being building blocks of ROA. The conclusion of the last writer supports the expectation of this report.

Defined as

Net profit after tax/Total assets X 100

Megginson (2007:52) defines ROA as:

Earnings available for common stockholders/total assets

Assets are used to produce income, which is why it is important to see whether it is being used effectively. Companies use employees and funds to generate revenue from assets. The effective use of the combination of funds and employees is expected to be a key factor in maintaining sustainable long term profitability.

2.3.1.2 Return on equity (ROE)

ROE relates income to the starting equity of that specific financial year. Equity over time is built up of the original investment of the owners of the company when created and adding or subtracting the net retained income year on year. Growth in equity over time indicates the actual value growth of the investment of the owners of the company.

Value–based management considerations in the listing of an agricultural company on the food producers sector of the JSE Ltd